Profiting from the Dollar&rsquo;s Might

The Eurozone mess has bolstered the greenback’s standing against almost all the world’s currencies. This could create some hard-to-resist bargains, writes MoneyShow’s Jim Jubak, also ofJubak’s Picks.

I know investors already have a long list of things to worry about: the euro crisis, slowing economies around the world and in the US, and the machinations of the Federal Reserve and the European Central Bank, to name just three.

But if you’re not watching the ins and outs of global currencies, you need to add this to your list. Understanding which currencies have been rising and which have been falling will help you understand the recent performance in not just stocks and bonds but also commodities and gold.

And that currency performance will also help you pinpoint some markets that will deserve a bit of your cash not too far down the road.

The recent big move in the US dollar versus almost all other global currencies—created by the current flight to safety—has overwhelmed longer-term fundamental trends. The rise of the dollar in the short term, I’d argue, has created some interesting bargains in the medium and longer terms, not just for currency traders but also for investors in global stocks.

An overvalued dollar—on its fundamentals—will, when the dust clears sufficiently, enable you to buy nondollar assets at bargain prices.

The Dollar on a Roll
You’ve undoubtedly been following the US dollar, especially against the euro.

That exchange rate has been a major driver of prices in the commodities market—as the dollar has climbed, the prices of oil and other commodities in dollars has fallen, because it takes fewer of these more-valuable dollars to buy a barrel of oil. And it has been a big part of the reason for the drop in gold prices and in the value of financial assets such as European stocks priced in euros.

Even after a slight gain against the dollar on Friday, after the disappointing US jobs report, the euro was down 7.6% against the dollar since the 2012 high (February 28) and down 15.3% since June 7, 2011.

And that’s had the effect of depressing stocks priced in euros. Certainly, a European luxury-goods stock such as LVMH Louis Vuitton MoÃ«t Hennessey (LMMUY) has its shares of worries that a European recession and slowing growth in China will reduce sales. But the dollar certainly hasn’t helped. During the period from June 7, 2011, when the euro fell 15.3% against the dollar, shares of Louis Vuitton fell 16.45%.

Of course, the dollar has been climbing against more than just the euro. Many of these currencies have held up relatively well against the dollar until recently.

The Australian dollar, for example, is down 11.5% from its 2012 high (on March 1) through June 1. Its total decline against the dollar over the last year isn’t a whole lot steeper, at 13.6% from its 2011 high on July 28. The big damage has come in the past month or so, with the Australian dollar falling 7% from April 30 through June 1.

Most global currencies show similar patterns of decline against the dollar, with the decline accelerating in the past few months. For example, the Brazilian real is down 24.5% against the dollar as of June 1, from its July 25, 2011 high. But more than half of that is from the 2012 high on February 28. From that date through June 1, the real is off 16.9%.

The Canadian dollar, which climbed regularly from December 19, 2011 to April 27, 2012 (a gain of 5.9%), has given it all back (and a bit more), with a 6.03% drop that has taken the loonie back to the levels it last saw in November.

Even the Chinese yuan has dropped against the dollar—or to be exact, the People’s Bank has let China’s currency drop against the dollar. The yuan declined 0.9% against the US dollar in May.

Part of that is a result of a decision by the central bank to let the yuan depreciate against the dollar inside its official trading range to give Chinese exports an edge in world markets—because they would cost less to overseas customers.

(The big problem here is with the euro. Since the yuan is effectively linked to the dollar, the rise of the dollar against the euro has made Chinese exports more expensive in Europe, China’s biggest export market. Letting the yuan depreciate against the dollar is a way to slow the yuan’s gains against the euro.)

The yuan has also been under some pressure because the pace at which wealthy Chinese are moving money out of China has increased since the recent purge of Bo Xilai.

It’s Not All About the Euro
Not all of the drop against the dollar has been a result of the Eurozone debt crisis, which has led currency traders and portfolio managers to seek the safety of the US dollar and dollar-denominated assets such as Treasuries.

Some of the drop in these currencies has been the result of negative developments in individual domestic economies. For example, the drop in the Canadian loonie comes as Canada’s own economy (so closely linked to that of the United States) has slowed, increasing the odds of an interest-rate cut there by the end of this year.

(Why? By reducing what investors get paid for holding assets denominated in Canadian dollars, an interest-rate cut decreases the demand for assets denominated in Canadian dollars, and thus reduces demand for Canadian dollars themselves.)

Similarly, the Brazilian economy has had difficulty gaining traction since the last round of interest-rates hikes from the Banco Central do Brasil to slow the economy and reduce inflation. On May 30, the central bank cut interest rates—by 0.5 percentage point—to a historic low of 8.5%.

The bank has now reduced rates by a full 4 percentage points since it began cutting rates in August 2011. The Brazilian real has, by and large, followed the bank’s benchmark interest rate downward.

In Australia, the central bank is expected to cut interest rates from the current 3.75% to 2.75% by the end of 2012 in order to stimulate an economy that is slowing in lockstep with softening Chinese demand for industrial commodities.

In Mexico, where the peso has declined by 12.4% against the dollar since March 13, the currency has moved down recently with data showing slowing growth in the United States, as well as polls on the July presidential election suggesting that the left-wing Party of the Democratic Revolution is closing the gap with the centrist (but once itself left-wing) Institutional Revolutionary Party, with the right-wing National Action Party falling to a weak third place.

Playing the Currency Swing
So what does all this mean to you?

I’d argue that the Eurozone debt crisis has led to a global fear trade that has pushed the US dollar to a higher price than is justified on the medium- and longer-term fundamentals of the US budget deficit, US political gridlock, and US economic growth.

That same fear trade has pushed down the currencies of countries such as Brazil, Australia, Mexico, Canada, Chile (the Chilean peso is down 7% from May 3 to June 1), Norway (the krone is down 9.2% from February 28 to June 1), and Sweden (the krona is down 9.9% in the same period) to levels that discount the better fundamentals of those economies.

At the moment, that means you can use overvalued US dollars to buy undervalued assets in the real, the Australian dollar, the Mexican and Chilean peso, the Canadian loonie, the Norwegian krone, the Swedish krona, and other currencies.

In the long run, you will be able to add the appreciation of those currencies against the dollar to whatever gains assets in those markets record.

In a global financial market, where what I’ve labeled the paranormal economy (see "5 Rules for an X-Files Market") will make 5% a year look like a great return, I don’t think investors can afford to ignore this kind of potential gain from currency swings.

Eyes on the Timeline
The big question, of course, is when?

When will the dollar stop climbing on troubles in the Eurozone? When will the global fear trade turn into a sporadic trade rather than the only trade? When will what I think are real but temporary problems in the economies of Brazil, Mexico, Canada, Chile, Norway, Sweden, and Australia make the turn toward improved growth and stable interest rates?

I think I can sketch in some currency price levels that I’d like to see before I dip my toe into these trades. For example, the euro at $1.20 would get my interest (although I know there are currency analysts on Wall Street who are talking about parity between the euro and the dollar).

The Australian dollar, to take another example, has support at 94.50 to 95 cents. (It finished Friday at 96.49 cents.) The consensus seems to be that the Banco Central do Brasil has stopped trying to force down the real, and will even look to defend the currency near current levels.

I can also sketch in a vague calendar. I think we’re looking at interest-rate cuts to draw to a close in Brazil, Canada, and Australia in the third quarter. Sweden and Norway might see one more cut, as the central banks in those countries try to keep their currencies from appreciating so much that they hurt exports.

The US presidential race will be over in November, and financial markets can begin to focus on how/whether/when the US will begin to deal with its budget deficit.

All that could—and I stress "could"—mean that we will see global currency markets start to move away from the dollar and toward these fundamentally stronger currencies in the fourth quarter. That would mean buying the stocks of these stronger currencies markets in November or so.

The Euro debt crisis is, of course, the great wild card. A true solution—one that takes fears of a Spanish default out of market calculations—would swing the markets against the dollar more quickly, as money managers realized they didn’t have to pay up for the safety of dollar-denominated assets.

On the other hand, a failure to come up with anything resembling a solution in the Greek crisis—likely forcing Greece to default and/or leave the Eurozone—and a failure to offer Spain anything except the path currently walked by Greece, Ireland, and Portugal would send the euro plunging through $1.20, and fear would push the dollar higher against all the currencies I’ve mentioned.

In other words, I think it’s wise to wait. As much as I like this overvalued dollar/undervalued non-dollar currencies trade, I don’t think the risk-reward ratio is yet slanted in my favor.

It’s time to research what to buy—and I’ll continue to add suggestions to my watch list—rather than to execute this strategy.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.